What's the intuition behind covered interest rate parity and when does it break down?

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AcadiFi · Accepted Answer

Covered interest rate parity (CIP) says that a fully-hedged foreign investment must earn the same return as a domestic deposit. If it didn't, you could borrow in the low-return currency, convert, invest in the high-return currency, and lock in the exit rate with a forward — printing risk-free profit. Consider Siegelstein Asset Management with a million euros. The EUR 6-month rate is 3.10%, the USD rate is 5.30%, spot EURUSD is 1.0850, and the 6-month forward is 1.0735. Strategy A (stay home): invest EUR at 3.10%, ending with 1,015,500 EUR. Strategy B (hedged USD): convert to 1,085,000 USD, invest at 5.30% yielding 1,113,753 USD, convert back at the forward to 1,037,634 EUR. Wait — that's more than Strategy A. ```mermaid flowchart TD A[1M EUR] --> B[Invest EUR
3.10%] A --> C[Spot convert
1.0850] C --> D[Invest USD
5.30%] D --> E[Forward back
1.0735] B --> F{Compare} E --> F F --> G[Must be equal
or arbitrage] ``` In strict equilibrium the two must equalize. Traders arbitrage any gap by borrowing the cheap leg and lending the expensive one. Post-2008, persistent CIP deviations emerged because banks face balance-sheet constraints under Basel III — doing the arbitrage consumes leverage ratio and funding costs that aren't in the textbook formula. End-of-quarter reporting windows especially widen the basis. The deviation is economic cost of capital, not a free lunch.

What's the intuition behind covered interest rate parity and when does it break down?

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